A new paper published by the International Monetary Fund (IMF) on Friday suggested a large-scale state intervention to both accelerate the transition from fossil fuels toward greener technologies and to help countries adapt to climate change.
The report entitled, ‘Industrial Policy for Growth and Diversification: A Conceptual Framework’, stated: “large-scale state intervention is also required to both accelerate the transition from fossil fuels toward greener technologies and to help countries adapt to climate change: tackling the problem in a coherent and effective way requires providing an analysis that identifies: the investments and innovations we need and the policies and finance that can draw through and support these investments and innovations.”
“Electric vehicles and renewable energy can be competitive with equivalent “dirty” technologies and yet have not been widely adopted. These challenges demand an urgent call for policies to help spur, scale up, and adopt green technologies across a wide range of sectors, from energy generation to transportation and industry,” the report stated.
“Here, advanced economies have a double responsibility: they must go beyond merely adopting green technologies themselves; they must also assist developing countries in doing so,” it said.
In the race to address climate change challenges, both advanced economies and developing countries must design, implement, and coordinate appropriate industrial policies. The negative externalities associated with carbon emissions represent a colossal market failure, affecting everyone across the globe. Carbon pricing, sectoral regulations, and financial-sector climate-risk assessments represent important tools to reduce emissions, according to the report.
Policy Instruments
The paper has also recommended the following five policy tools governments need to consider while diversifying industries and facilitating industrial growth. The authors provided a taxonomy of policy tools commonly employed to implement targeted sectoral interventions.
The authors consider five categories of instruments: (1) technology, (2) product market, (3) capital market, (4) labor market, and (5) land market. The paper briefly discussed some of the risks they generate and the evidence on their effectiveness.
The authors then consider each category separately; however, different policy instruments can complement or, conversely, offset each other. For instance, trade liberalization, combined with reforms to increase labor-market flexibility, can ease the reallocation of workers to more competitive sectors. And these policy tools can be used for purposes beyond sectoral targeting, such as providing infrastructure, boosting participation in global value chains, or developing resilient production networks.
A- Technology
R&D tax incentives and subsidies are typically justified based on the significant externalities from one firm’s R&D on the productivity of other firms. They could prove particularly effective for export diversification, by reducing the risk involved in adopting foreign technologies and developing new export sectors.
Governments also often engage in R&D themselves, provide direct funding for it, or set up public-private research consortia. Governments can support digitalization by providing important information and communications technology infrastructure, including strengthened cybersecurity; creating regulatory sandboxes to encourage experimentation; helping establish sector-specific digital platforms; and boosting the digital skills of the workforce.
B- Product Market
Trade Policy Import tariffs and nontariff barriers, including import quotas, local content requirements, and export subsidies are often justified on “infant-industry” arguments, to develop a sector that will eventually prove viable even without public support (Greenwald and Stiglitz 2006).
The global trading regime currently restricts these instruments, and alternative tools should be carefully designed to ensure consistency with World Trade Organization (WTO) rules. Other measures currently being used to promote exports and/or encourage participation in global value chains include differential tax rates for profits from export sales, import-tariff rebates on imported intermediates, and credit lines for exports. Subsidies to foreign investors on the purchase of domestic inputs can achieve the same outcome as local content requirements.
Industry case studies find that, even when protection allowed domestic producers to grow and become competitive, it often led to net welfare losses even in the East Asian miracle economies. What you protect seems to matter.
Tariffs on capital and intermediate goods are especially likely to reduce growth, partly because such imports embody new technology. The protection of skill-intensive sectors is more likely to be associated with faster growth, at least in countries with good governance.
Tax Incentives to Promote Investment: Tax holidays and exemptions, special corporate tax structures, targeted allowances, and subsidized infrastructure are sometimes justified as a second-best option when the economywide corporate income tax is relatively high. The emphasis is often on attracting foreign direct investment (FDI), which is viewed as generating particularly strong spillovers, including through improved technology and management techniques.
The State as a Producer and Consumer: As producers, states often enter “strategic” sectors through state-owned enterprises (SOEs). Typically, these sectors have strong upstream or downstream linkages, but require large fixed-capital investments and a long-time horizon; examples include water, electricity, and other types of infrastructure.
As consumers, states can provide a stable source of adequate demand through public procurement agencies. For instance, recipients of government support may be required to source a portion of their production domestically.
Measures to Reduce Informational Frictions: Informational gaps and asymmetries may be addressed more directly by promotion agencies that match buyers with suppliers. For instance, export promotion agencies may organize fairs, linkage programs, and other services such as quality certification schemes that facilitate domestic and foreign investments.
Such measures are often referred to as “soft industrial policy. Such schemes are particularly likely to boost exports where they provide a clear and effective one-stop shop, as opposed to multiple agencies that employ unclear mandates, involve significant coordination with the private sector, and promote increases in product quality or complexity.
C- Capital Markets
Securing financing to enter new sectors is particularly difficult where the financial sector is underdeveloped or expected to comply with stringent prudential restrictions, so that financial intermediaries have short investment horizons or are very risk averse, and borrowers find it difficult to establish collateral.
Various capital-market interventions have been justified on the grounds that governments may have longer investment horizons, or better information than private lenders on the riskiness of a particular investment.
Also, given weak property rights, the public sector may have a better chance of having a loan repaid. Further, intervention may signal to private investors that the government has “skin in the game” and is committed to the reforms necessary for the industry to succeed. On the other hand, such interventions generate costs, whether direct or indirect, and they may crowd out other investment opportunities.
Directed and Direct Lending: Government can instruct commercial banks to allocate a proportion of their lending to a particular sector. The evidence on the impact of directed lending is mixed, but it can boost production when the targeted firms are severely credit constrained.
However, it can also undermine financial sector profitability. Alternatively, the public sector may lend directly, often through specialized public sector development banks or export-import banks. This will increase the public sector borrowing requirement. If the credit is provided at interest rates below what a commercial bank would normally change, then this support is akin to a subsidy which has a fiscal cost.
Credit Guarantees: Governments may provide loan guarantees to support credit flows to firms from commercial banks or investors. The use of such schemes has expanded considerably in the wake of the COVID-19 pandemic. This intervention does not require the government to set up a specialized financial vehicle. However, such guarantees create a contingent liability for the public sector.
The beneficiaries of the guarantee may also misuse the funds. Improper or imprudent use of loan guarantees can have significant adverse impact on public financial management and fiscal policy.
Few rigorous evaluations of guarantee schemes have been undertaken. In general, it is difficult to identify schemes that resulted in appreciable increases in lending, and several have suffered significant losses.
Venture Capital and Incubators: In advanced economies, venture capital and private equity firms play an important role in providing financing to start-ups. These financial firms are often missing in developing countries, especially in low-income countries. Public intervention can help develop this sector.
Governments can also set up public bodies to play the role of venture capital firms. Related, governments are increasingly setting up or lending support to start-up incubators. These incubators can provide a range of services, such as capital, public land, and expertise, and often engage with public universities.
D- Labor Market
Skills Development Sectors may face a shortage of required skills. To close this skill gap, governments can grant tax credits or subsidies to firms, industry associations, and skill councils that provide training. Governments can also directly create vocational training institutions geared toward industry-specific skills, partially funded through payroll levies in the targeted sectors.
The effectiveness of such measures depends on the degree of collaboration with the targeted sector in designing and delivering training, including apprenticeship in firms. Success may also require a more general strengthening of primary and secondary education.
Labor Taxes: Governments can lower labor costs in favored sectors by selectively reducing payroll taxes. Alternatively, they may provide tax holidays or credits to investors based on employment creation. To meet OECD regulations these incentives need to be very limited in terms of the sectors targeted, but any specificity may violate WTO rules against export-targeted subsidies.
These selective tax reductions can be successful but may also simply provide windfalls to the favored sectors with limited impact on employment. To increase the chances of success, policy should impose minimal constraints on firms’ operations and productivity, giving firms flexibility to adjust their business models. Avoiding overly stringent conditions on hiring (for instance, local labor-content requirements) has proved important in several successful cases.
E- Land Market
Cheap Land: Governments can provide access to public land at below-market rates for a new activity. This may be a second-best response to land-tenure regulations that limit access to land for factories or impact the use of land as collateral.
It may prove particularly attractive to foreign investors who find it challenging to negotiate the local land market. However, this response incurs an immediate fiscal cost. State-owned enterprises (SOEs) often receive preferential access to cheap land; a more neutral approach to land distribution could potentially enhance the effectiveness of industrial policy. In addition, well-defined land and property rights would provide necessary incentives to develop agribusiness.
Special Economic Zones: Special Economic Zones (SEZs) may provide firms with better infrastructure and public services, as well as corporate tax and import duty exemptions, more streamlined regulations, and other product market incentives. While some SEZs allow only foreign firms, others accommodate domestic firms.
SEZs can be helpful where countrywide reforms face political economy constraints, and/or the government is unable to provide good-quality infrastructure and services throughout the economy.
However, SEZs can reduce government incentives to implement more comprehensive reforms, such as trade liberalization or infrastructure upgrading (Leong 2013). SEZs can also have limited spillovers to the rest of the economy, depending on how they are designed and function in practice, according to the IMF report.